September 13, 2023
On September 11, 2023, the SEC announced charges against nine registered investment advisers for advertising hypothetical performance on their websites without meeting the requirements of the Marketing Rule. All nine firms have agreed to settle and will pay penalties ranging from $50,000 to $175,000. These charges come several months after the SEC announced the expansion of its marketing sweep exams and only a few weeks since the enforcement against Titan Global Management for misrepresenting hypothetical performance.
“Because of their attention-grabbing power, hypothetical performance advertisements may present an elevated risk for prospective investors whose likely financial situation and investment objectives don’t match the advertised investment strategy,” said Gurbir S. Grewal, Director of the SEC’s Division of Enforcement in the SEC press release. The SEC has made it clear from the beginning that the use of hypothetical performance will be scrutinized. Implementing policies and procedures and ongoing review of advertisements for compliance must occur if your firm wants to present hypothetical performance in compliance with the Marketing Rule.
Hypothetical Performance under the Marketing Rule, 206(4)-1(d)(6))
Investments advisers may not include in any advertisement any hypothetical performance unless the investment adviser:
The Common Mistake These Advisers Made
It is impossible for an adviser to present hypothetical performance to the general public on a website and simultaneously ensure the performance is “relevant to the likely financial situation and investment objectives of the intended audience.” Hypothetical performance must only be disseminated to an intended audience. Only then can an adviser ensure the presentation is relevant. All nine of these firms failed to meet that first step by allowing anyone to see their hypothetical performance advertisements.
Once an adviser has made use of its policies and procedures to narrow the presentation to an intended audience where it would be relevant to the financial situation and investment objectives of the intended audience, there are still two more requirements to overcome.
First, disclosures of the criteria used and assumptions made in the calculations must be provided and they must be sufficient to enable the intended audience to understand them. Here again, disclosures must be tailored to a specific audience. Disclosures of criteria and assumptions will never be sufficient for a mass audience because of the wide range of financial literacy in such an audience.
Second, the adviser must provide, or offer to provide promptly to private fund investors, sufficient information for the intended audience to understand the risks and limitations of relying on hypothetical performance for making investment decisions. Sufficiency will depend on the capability of the chosen audience. The question is, will the SEC believe your disclosures are enough for the audience to truly understand the risks.
The SEC’s Expectation
The SEC does not want retail investors seeing hypothetical performance. This is clear from the string of enforcements, the marketing sweep exams and their description of the rule itself. In the adopting release to the new Marketing Rule the SEC made clear that only investors with the resources and sufficient financial expertise to understand hypothetical performance should ever be shown such advertisements:
“We intend for advertisements including hypothetical performance information to only be distributed to investors who have access to the resources to independently analyze this information and who have the financial expertise to understand the risks and limitations of these types of presentations.” Pg. 200, Release No. IA-5653.
A general audience could never meet this intention of the Commission. The sweep exams and the recent enforcements go to show that the SEC meant what they said. Hypothetical performance can still be presented in advertisements, but pains must be taken to do so compliantly. If your firm wants to present hypothetical performance, take the time to review your policies and procedures, narrow disseminations to an intended audience, draft tailored disclosures on criteria, assumptions, risks and limitations, and double check that your intended audience has the resources and expertise to analyze the performance shown.
What does this mean for me?
Some take-aways from these enforcements:
Take a risk-based approach for your firm. Hypothetical performance can be shown to some investors, but you must take on the burdensome process of complying with the new Marketing Rule treatment of hypothetical performance.
Fairview® provides full-service compliance support for registered investment advisers by creating and implementing comprehensive, sustainable compliance programs, including ongoing testing and evaluations to ensure firms are remaining compliant with SEC regulations. We make sure that internal controls are built into your operations processes, making compliance features inherent to the culture of your firm. Contact us today for additional information about maintaining your compliance program.